Who’s afraid of a downgrade- asks Old Mutual Wealth
The dust has now settled somewhat following the disappointing Medium Term Budget and, lo and behold, markets are mostly up. While some have attributed this to relief that Moody’s decided not to downgrade the credit rating on government bonds to junk status, it’s not a very convincing explanation. After all, Moody’s made it clear that it needs to see concrete measures to stabilise the government’s debt ratios in the February Budget. That is only three months away.
A downgrade is therefore still very much on the cards. The more important question is how much should this concern investors. The short answer is that the broader context matters, but more on that later. Markets are up over the past week because global risk appetite has perked up, and South African assets usually benefit when this happens. For better or worse, we are highly geared to changes in risk appetite, as our deep and liquid financial markets mean investors can easily trade-in and out of local assets to express global views. The rand is also one of the most widely traded currencies among major emerging markets, according to the Bank for International Settlements (the central banks’ central bank) survey of foreign exchange turnover.
With the US and China agreeing not to escalate the trade war, and even possibly to roll back some of the past tariff increases, a big downside threat to the global economy receded. As it stands, the latest data available shows that, while global growth has slowed considerably, fears of a global recession were overblown. Manufacturing is definitely declining, though the worst seems to be over. Overall growth is still being held up by consumer spending in the developed world.
Indeed it is the weakness in manufacturing that is probably pushing the US to soften its stance on China. President Donald Trump faces an election in a year’s time. To win he needs to carry the so-called swing states – states that switch between supporting Republican and Democratic candidates. He particularly needs to repeat his performance in Wisconsin, Michigan and Pennsylvania, where support from blue-collar workers helped him win by razor-thin margins in 2016.
However, the latest employment surveys show manufacturing employment has declined in all three of these states in the past year. Overall US manufacturing is still adding jobs, and employment for the economy as a whole expanded 1.4% in the year to October. With wage growth steady but unexciting around 3%, it means overall household income growth is slightly more than 4%. With inflation below 2%, this implies decent real income growth that supports household spending, the largest driver of economic growth by far in the world’s largest economy. Therefore, the US economy is growing at a 2% annual pace in real terms (after inflation). The Eurozone is growing at 1%, and China at 6%. These growth rates are all lower, but remain positive.
Fed down, not up
Importantly, a year ago, the US Federal Reserve (the Fed) was still happily hiking interest rates and was promising to continue doing so into 2019. Instead, it cut rates three times. No further cuts are expected as we head into 2020, but nor are any hikes on the cards. The Fed and its sibling central banks are not going to be responsible for a global recession.
Chart 1: Global equities in US dollars
Source: Refinitiv Datastream
With downside risks having diminished, more investors can reach for upside in growth and high yielding assets. Global equity returns for 2019 to date are north of 20%. The panicky lurch lower in developed market bond yields, pushing many into negative territory, has also eased, though it is still very much a low global interest rate environment. This is a much safer global backdrop for South Africa, irrespective of progress or lack thereof on domestic challenges.
So what would a Moody’s downgrade mean? Firstly, South African government bonds are already rated sub-investment grade (‘junk’) by S&P Global and Fitch. The sky did not fall on anyone’s head when these downgrades happened, despite much wailing and gnashing of teeth. The simple reason is that markets react in real time to the information ratings agencies incorporate in their models. Ratings agencies make periodic announcements, but markets price the most likely future scenario in immediately. Moody’s is the last major ratings agency to maintain South Africa’s investment grade rating. This is not because it is more generous or patient than the other agencies, but reflects the fact that each agency has its own methodology.
Moody’s methodology places a large weight on institutional strength, and it is hard to argue that this has not improved over the past two years, even if the fiscal situation has deteriorated.
The reason so many analysts worry about a Moody’s rating specifically is that a downgrade by Moody’s would lead to South African bonds being excluded from the FTSE World Government Bond Index. Funds that passively track this index would have to sell out. Active funds that use it as a benchmark would have likely sold out long ago. No one has a firm grip on the extent of potential passive outflows, but it’s estimated to be between R20 billion and R200 billion.
However, most foreign investors are here for the yield, not the quality of the rating. In any event, while a downgrade announcement can cause volatility, it is unlikely to fundamentally change borrowing costs or the level of the exchange rate. South Africa has already seen cumulative net outflows of R125 billion over the past two years, according to JSE data. Despite this, long bond yields are essentially flat over this period.
These yields remain high and have detached from other emerging markets, even ones with higher debt levels, who have seen much lower yields (see chart 2). Ultimately, it depends on global risk appetite. Bonds rallied and foreign purchases surged in 2016 in the aftermath of ‘Nenegate’ and ratings downgrades for the simple reason that international investors switched large-scale into emerging markets. South Africa benefited despite deteriorating fundamentals.
Chart 2: 10-year local currency bond yields
Source: Refinitiv Datastream
In other words, there are many things to worry about in South Africa, but Moody’s should not be top of the list. While some have argued that the threat of a downgrade is good for spurring the government into action, it could equally be considered a deterrent to investment as some businesses and individuals sit on the side-lines until they know the outcome. And unfortunately, this has dragged out for many years now.
Not all businesses are sitting on their hands. A reported total of R363 billion in business investments was announced at President Ramaphosa’s second investment conference. This represents a healthy increase over the amount pledged last year, but clearly those investments have not contributed much to economic growth, which remains anaemic overall (and was possibly negative in the third quarter). These investments are implemented over a number of years, so the actual amount being spent this year and next will not move the needle much. Total private fixed investment spending was R873 billion in 2017 and 1.5% higher in 2018 at R886 billion.
In other words, even in a tough economic climate, companies spend more than R800 billion on machinery, vehicles, buildings, software and the other necessities of running a business. When businesses get excited about the future, they will spend a lot more. Business investment peaked at 15% of GDP in the tail-end of the pre-2008 boom. Today the number is much lower at 13.5%. However, it must be said that this is well above the average of the 1980s and 1990s.
Chart 3: Public and private fixed investment spending as percentage of SA GDP
Source: Refinitiv Datastream
The one element that ties all of this together is economic growth. Faster economic growth will improve debt and deficit ratios by lowering the numerator (debt and borrowing) and raising the denominator (GDP). This in turn will reduce pressure from the credit rating and give the Reserve Bank greater comfort to cut interest rates. Lower rates in turn will boost growth. Faster growth will fire up the ‘animal spirits’ of business leaders to invest more to capture a slice of the growth. This is the kind of virtuous cycle we need. Instead, it still seems to be going in the other direction.
In the absence of faster growth, the government will have to limit spending growth to prevent debt from rising too quickly. This is easier said than done, and comes with its own implications. Fixed investment spending by the broader public sector is usually the first item to be cut, and it has already declined from 7.6% of GDP in early 2016 to 5.6% in the second quarter. Cutting the wage bill is politically difficult and not something that can be achieved in the short term, since the government is tied into a three-year wage agreement. There are no silver bullets unfortunately, and historically, growth spurts have been as a result of external conditions (i.e. commodity prices and capital inflows), rather than generated internally.
What government needs to do is make it easier and cheaper to do business. This means facilitating investment in infrastructure and skills, delivering essential services and removing unnecessary regulations. Much like the Springboks’ World Cup winning performance, the key is doing the basics right. President Ramaphosa has pledged to move South Africa into the top 50 of the World Bank’s Doing Business Survey in the next three years. This international comparison focuses on the ease of opening and running a business. Some reforms already in the pipeline will help raise South Africa’s competitiveness over time. Things are moving in the right direction, but clearly not at the speed most want to see.
Stick to the plan
Government should also address the persistent uncertainty caused by some of its own proposed - but not implemented - policies. Importantly in this regard, Finance Minister Mboweni noted last week that Treasury was not considering implementing prescribed assets. Therefore, while local investors have a lot to think about, there is no need to fear the government ‘raiding’ your retirement savings. Although a Moody’s downgrade is by no means a good thing, it is also not something that should scare you into making unnecessary portfolio changes. Therefore, while it might not always seem like government has a plan, individual investors should have one for their finances, and stick to it.